Donald Trump has made and lost fortunes in real estate. And while you may never earn enough money to hire your own apprentice, you can use some of the same techniques that The Donald uses to cut your taxes and add to your savings.
Beyond the basics
If you own your home, you're probably already familiar with most of the typical tax breaks that homeowners get. Most taxpayers can deduct the interest they pay on their mortgages. The money you pay for property taxes is deductible as well. You also may qualify for tax credits for certain types of home expenses, such as the credit for energy-saving renovations. Then, when it comes time to sell, you won't have to pay capital gains on up to $500,000 of the appreciation in your home's value. All in all, being a homeowner carries a lot of tax percs with it.
But to experience the full range of tax benefits that come with real estate, you have to go beyond your personal residence. Real-estate investors, developers, and property managers are eligible for a wide range of tax breaks that make homeowners' deductions look like peanuts.
Taking an active role
If you've ever considered actively investing in real estate, you'll find a number of favorable tax benefits will help you on your way. Many real-estate investors start out by buying a second home or small apartment building and renting their properties out to tenants. If you choose your property carefully, rentals can turn into gold mines, although the time involved in managing your property may make it feel more like a second job than an investment.
Part of what makes owning rental property so attractive is being able to take additional tax deductions. In addition to expenses like loan interest and property taxes, you'll be able to deduct a portion of the value of your property each year as depreciation. Furthermore, expenses you incur in managing the property, such as transportation, property insurance, repair and maintenance costs, and professional fees are usually deductible against your rental income. For many owners, these deductions add up to the point where a substantial portion of their profits from their rental properties are essentially tax-free.
Similarly, if you own land with development potential, you may be able to create a business based around developing your property. Although home-building companies like Centex (NYSE: CTX ) , Toll Brothers (NYSE: TOL ) , and Pulte (NYSE: PHM ) are constantly looking for promising new land for their developments, you can also take a more active role and build partnerships with local construction companies to develop your land on your own. However, this is a two-edged sword. While having a real estate business may let you take deductions for additional expenses, it may also expose you to two big tax problems. First, you may be treated as self-employed and have to pay self-employment taxes on your profits at rates up to 15.3%. Second, while sales of investment property usually qualify for capital gains rates, property in a real-estate business often constitutes inventory, which is taxed at higher ordinary income rates.
Passive investors in real estate
Even if you're not interested in becoming a landlord or creating a new subdivision in your neighborhood, you can still get tax benefits from real-estate investing. One provision of the tax code allows you to exchange your investment real estate for another piece of property without incurring capital gains. This technique, known as a like-kind or 1031 exchange, can be extremely valuable if you own a highly-appreciated property.
For instance, if you bought a vacant lot in Los Angeles 40 years ago for $10,000 and it's now worth $500,000, selling it could cost you more than $100,000 in federal and state income tax. However, if you exchange the lot for another piece of real estate of equal value -- say, for instance, an income-producing property -- then you won't have to pay capital gains tax. This would allow you to start collecting income from your investment without paying the tax from a normal sale.
There are special rules to follow to qualify for like-kind exchange treatment, and specialized businesses have sprung up to help navigate real-estate investors through the rules. There's a lot of flexibility in what qualifies as a like-kind exchange, however, which can make owning real estate even more attractive for an investor.
Since the founding of our nation, real estate has helped build fortunes for many families. Even if you don't aspire to be the next Donald Trump, you can use the tax benefits available to real estate investors to your advantage. If you're successful enough, maybe you'll be able to afford that apprentice after all.
Taxes are a way of life, but you can learn what you need to know to keep your taxes low in our Tax Center.
Fool contributor Dan Caplinger has always been intrigued by real estate, even if Donald Trump scares him a little. He doesn't own shares of the companies mentioned in this article. The Fool has a disclosure policy.